By law, regulatory agencies should only regulate that which they have authority to regulate. Deference is allowed to some degree, should the agency’s justification be reasonable and ideally evidenced. Notably Congress promulgated the Administrative Procedure Act (APA) in 1946 to guide agency process to publish notice of rulemaking in the Federal Register and provide opportunity for public comment. This standard process seems to have never have happened for crypto assets at the Security and Exchange Commission (SEC). The SEC website does not include an entry for regulation for crypto, either completed or proposed.
In May 2022, the SEC beefed up its Cyber Unit to the Crypto Assets and Cyber Unit, budgeted for 50 dedicated officers and more than doubling the department’s headcount. The unit counts some 200 lawsuits since its founding in 2017, with fraud being the subject in at least 80 investigations. The agency also reports restoration of $2 billion in monetary relief.
No one denies that crypto assets, like any asset or technology, can be used fraudulently. The very features that make crypto assets desirable can also be exploited, including but not limited to ease of startup and use, anonymization, and lack of intermediaries. Plus, some users can undoubtedly be greedy and gullible. It does not help that some have disguised crypto scams as legitimate services.
It’s true, as well, that at least $1 billion had been lost to crypto fraud in 2021. However, this pales in comparison to more than $15 billion lost overnight by investors when the SEC brought a $1.3 billion non-fraud lawsuit against enterprise blockchain company Ripple Labs. When the news dropped, exchanges stopped trading XRP currency.
The SEC’s broad-brush approach which a priori singles out all crypto offerings, exchanges, lending, decentralized financed, non-fungible tokens, and stablecoins looks like guilty until proven innocent. So many lawsuits suggests that the SEC prefers “regulation by enforcement” (a lawsuit against a financial actor meant to extract a settlement) rather than “regulation by rules” (express guidelines for the trade of currencies, securities, and other assets). If the SEC can devote 50 amongst 4000 employees to detect crypto fraud, a handful could work on rulemaking to help legitimate crypto actors.
The SEC has not responded to my request for comment.
The Chairman’s View
In a recent op-ed titled “The SEC Treats Crypto Like the Rest of the Capital Markets. Securities laws that protect investors continue to apply even when new technologies come along,” SEC Chairman Gary Gensler made a seemingly reasonable pitch for investor protection against fraud and claimed that SEC rules protect against this. Indeed he claimed that crypto lending is already subject to SEC regulation and that “the rules have been around for decades.” However a cursory search on SEC.gov on the term “crypto lending” only yields results related to the SEC’s BlockFi enforcement, no “rules” as such. Instead the Chairman advises, “I encourage platforms offering crypto lending to come in and talk to SEC staff.” What is www.SEC.gov for if not to read rules?
On various occasions Gensler observed that every digital asset is probably a security and that every firm should know that. However this not what the SEC said in the past (see the 2018 William Hinman speech). There is principled, ongoing debate in legal and academic communities that crypto assets could be either currency (medium of exchange) or security (investment in an asset with an expectation of return) or both. This important distinction is not explicit on SEC.gov and the SEC acknowledges both categories exist.
This question of currency or security is at the heart of SEC v. Ripple Labs and the status of the digital currency XRP. Apparently SEC leaders themselves debated the question internally for some time, but never conducted an inquiry or rulemaking. Magistrate Judge Sarah Netburn has repeatedly ordered the internal documents on the 2018 speech be produced to Ripple in discovery, but the SEC refuses to comply. Her July Opinion & Order blasted the agency for “hypocrisy” and behavior which “suggests that the SEC is adopting its litigation positions to further its desired goal, and not out of a faithful allegiance to the law.” The SEC further charges that Ripple should have known XRP was security from the ledger’s debut in 2013, even though the SEC itself didn’t know until it filed the suit in 2020.
A similar argument underpins SEC v. LBRY, though it involves a different technology and objective. Gensler observed at a speech at the 2021 Aspen Security Forum, “Make no mistake: It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime.”
Complying with the SEC’s securities regime is a tall order for any enterprise, whether a major bank or a lone developer. That fellow SEC Commissioner Hester Peirce posted a proposal for a token safe harbor to “facilitate participation in and the development of a functional or decentralized network, exempted from the registration provisions of the federal securities laws for three years” suggests that the SEC’s rules are less than clear.
At the Aspen event, Gensler also claimed that the Supreme Court’s Howey benchmark is a “three part” test, when it is in fact four. The critical fourth prong is the “investment contract” defined as an investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others. It appears that Gensler eliminated this because it contradicts the reasoning in the Ripple and LBRY cases, which posits that the tokens per se are securities regardless of how they are packaged and sold.
What the SEC should do
The SEC was founded in 1934 in reaction to the 1929 stock market crash and with the purpose to protect markets from manipulation. However the SEC’s own actions to “regulate by enforcement” are a kind of manipulation through arbitrary and capricious decisions and lack of process and rules.
Indeed, some 90 percent of SEC cases are settled, rather than concluded in court. Such a high degree of enforcement and settlement suggests that SEC rules are not clear and possibly non-existent.
There are hundreds of SEC lawyer tasked with prosecuting companies for failure to follow rules that Gensler says exist but which cannot be found on SEC.gov. Gensler can protect investors through transparency. Crypto actors have begged Congress and the SEC for clear rules for years, but it hasn’t happened. Gensler has been on the job for a year a half. It’s time to get this done.
Note: The title and content of this article were updated from an earlier story which could have been misinterpreted as news, when it was meant as analysis. Neither the author or her family members own or engage in the trade of digital assets, XRP, bitcoin or the like. The author accepts no outside compensation, financial or otherwise, for covering this important regulatory policy topic. The author has no relationship with any of the parties in this story.